BoC cuts rate to 0.5%

“They have braced themselves for poor results ahead,” writes CIBC chief economist Avery Shenfeld in a research note. The central bank expects GDP growth to resume in Q3, led by the non-resource sectors of Canada’s economy. “The first good quarter [is] not due until Q4 (at 2.5%),” he says. “That actually makes a further cut less likely, as the low bar for the next few months makes it unlikely that they will be disappointed.”

Douglas Porter, chief economist at BMO, says “notably, the [BoC] did not use the R word [recession]” when referring to GDP growth. In Governor Poloz’s press conference, he again refused to call the growth slowdown a recession, saying, “I’m not going to engage in the debate of what we call this. […] I want to focus on is the other 80% of the economy that appears to be growing quite well.”

Shenfeld says, “Markets hadn’t fully priced in a cut this month, but had already built in a cut for later in the year, reducing the market impacts of the move today.” He predicts the CAD could fall below US$0.77 “as we get closer to a Fed hike.” The CAD was US$0.775 as of 11:05 am ET.

TD Canada Trust was the first bank to decrease its prime lending rate in response, lowering it by 10 basis points to 2.75% as of July 16, 2015.

A CIBC poll found this week that nine in 10 people would not borrow more in response to a rate cut; in fact, one-third said they’d pay off debt faster. Canadian households owe $1.63 for every dollar of disposable income.

“Rate cuts by the Bank of Canada are more effective at the higher end of the rate spectrum—where sub-primers reside,” points out Benjamin Tal, deputy chief economist at CIBC, in a July note. “So any further cuts by the bank might fuel borrowing exactly where it’s not needed.” He argues a rate cut could lower the loonie by a few cents, but that’s “a small positive, [and] not a game-changer by any stretch of the imagination.”

He argues the BoC is running out of tools and that fiscal policy must now play a role in lifting our economy. But, in an election year, he says it seems “balancing the books is more important.”

Context for the decision

Total CPI inflation in Canada has been around 1% in recent months, reflecting year-over-year price declines for consumer energy products. Core inflation has been close to 2%, since disinflationary pressures were offset by past depreciation of the Canadian dollar and sector-specific factors. So, the Bank sees the underlying trend in inflation is about 1.5% to 1.7%.

Global growth faltered in early 2015, principally in the United States and China. Recent indicators suggest a rebound in the U.S. economy in the second half of this year, and growth is expected to be solid through the projection. Many economists predict the Fed’s first rate hike will occur in September.

In contrast, China is slowing. This has pulled down commodity prices that are important to Canada’s exports. Financial conditions in major economies remain very accommodative and continue to provide much-needed support to economic activity. Global growth is expected to strengthen over the second half of 2015, averaging about 3% for the year, and accelerate to around 3.5% in 2016 and 2017.

Read: Rate cut won’t prompt Canadians to borrow more: CIBC

The Bank’s estimate of 2015 Canadian growth is down considerably from its April projection. That’s because of downgraded investment plans in the energy sector, as well as weaker-than-expected exports of non-energy commodities and non-commodities. Real GDP is now projected to have contracted modestly in the first half of the year, resulting in higher excess capacity and additional downward pressure on inflation.

Recent evidence suggests a pickup in activity and rising capacity pressures among manufacturers, particularly those exporters that are most sensitive to Canadian dollar movements. Financial conditions for households and businesses remain stimulative.

Read: IMF slashes outlook for Canada’s growth

The Bank now projects Canada’s real GDP will grow by just over 1% in 2015 and about 2.5% in 2016 and 2017. With this revised growth profile, the output gap is significantly larger than was expected in April, and closes later. The Bank anticipates that the economy will return to full capacity and inflation to 2% on a sustained basis in the first half of 2017.

The lower outlook for Canadian growth has increased the downside risks to inflation. While vulnerabilities associated with household imbalances remain elevated and could edge higher, Canada’s economy is undergoing a significant and complex adjustment. Additional monetary stimulus is required at this time to help return the economy to full capacity and inflation sustainably to target.